Long Straddles - When to Enter Them

by Owen Trimball
(Adelaide, Australia)

I have been doing option trading for a while and learned by experience, that one of the greatest threats to profitability, is option time decay. The worst thing about it, is that it just creeps up on your gradually - it's not like you see your positions "go the wrong way" and you KNOW you're losing.

For this reason, anyone who contemplates entering a straddle position should have good reason to believe that within a SHORT TIME, the price of the underlying will EXPLODE in one direction or other.

If no move during a predetermined period of time, you should exit the position, hopefully with at least breakeven if one side of the trade has moved at least enough to cover the losses on the other.

However, here are the best conditions I can suggest, as a prerequisite to entering straddle trades.

1. Research upcoming earnings reports and choose a stock that is due to release a report in about 3 weeks time. Often, a stock's price will "run up" or down prior to the earnings report being released, as a reflection of market anticipation of what the report will contain. Just as often, once the report hits the market, the price can also react violently if such anticipations are not realized.

2. Look for "symmetric triangle patterns" on charts. This is where you see "lower highs" and "higher lows" so that the stock price is consolidating into a narrow range. At the same time, check that the historical price action is volatile enough to warrant an expected breakout. Consolidating stock prices are more often than not like a "pressure cooker" waiting to explode in one direction or another.

The above two conditions are ideal setups for entering straddle trades. The beauty of straddles is that it is a non-directional trade. You don't care which way the stock moves, as long as it goes "somewhere" within the next month at most.

Finally, only EVER enter straddle option positions with AT LEAST 90 days till option expiry. You want to minimize your exposure to option time decay and also allow enough time for the trade to realized a profit.

TSO Reply: Hi Owen. Thanks for your generous sharing of valuable experience. I would like to add in a few points to elaborate on the suggestions and conditions that you have brought up for the sake of other less experience traders.

Long Straddles is a volatility strategy and we do not have any bias on the directions of the stock. Having said that, if the volatility is forcing the stock to move upward, we would prefer the stock to continue to move in the upward direction and not coming down (whereby it will erase our unrealised profit). If the volatility is forcing the stock to move downward, the preference is of course for the stock to continue to drop all the way!

1. On the timing of entry into the trade, ideally you should have entered the Long Straddles position before the volatility spike occur and sell it after it happened.

There is not a rigid rule as to when the volatility spike will occur before the news event. However, it usually occurs 1 week before the news. Therefore, this would require you to place the trade much earlier. By doing so, time decay is against you. Hence, it is always advisable to look at options that expire between 2 to 4 months to maximise the profit potential of this strategy.

One popular strategy is to enter into the Long Straddles position well in advance before the news announcement (eg 1 month). Then you sell off the position after the volatility spike had occurred but before the actual news announcement. By doing so, you will be able to profit from the increase in volatility but reduce the risk of any post news collapse of volatility. The flip side of doing so is of course you may be earning less from not participating in the Explosion of volatility after the news is announced.

2. Chart reading of the stock is a huge topic. Before you enter into the volatility trade, ideally you should try to select those stock that has a fairly neat looking chart with easily identifiable chart pattern. By being neat usually represent the “calmness” before the storm. Preferably you should be able to note that the stock do make a sharp move in either directions from analysis of the past.

Choose your strategies according to your outlook of the underlying stocks. Once you have analysed the probability of the stock overall direction, trade using the correct option strategies applicable to the stocks.